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Continental Illinois

Introduction credibility to the notion that controls and risk monitoring at the
some banks should be centre of the bank.
On May 9, 1984, Continental considered too big to fail. Deteriorating credit portfolios,
Illinois,1 Chicagos largest bank leading to market rumor and the
and one of the top ten banks in The emergency help was withdrawal of competitively priced
the US, began a frantic battle followed by a package of funding, can send even large
to counter reports that it was on permanent measures, institutions careening down the
the brink of insolvency from a making Continental the liquidity death spiral.
combination of bad loans and largest bank in the history of Some banks might be too big to
funding liquidity risk. US banking ever to be fail from depositors and regulators
rescued by government point of view. But shareholders
At the root of the crisis lay a agencies.2 The FDICs share will still lose their shirts.
massive portfolio of energy of the bill was later
sector loans that had begun to calculated to be $1.1 billion.3 The story
turn sour on Continental when
the US oil and gas sectors The Continental story In the mid 1970s, Continental Illinois
lurched into recession in 1981. provides a classic and embarked on a strategy of growth that
The $33-billion asset bank had timely4 example of how a over the next half-decade would make
compounded its mistakes by sharp drop in confidence can the bank the largest commercial and
lending large amounts to lead counterparties in the industrial lender in the US. As a
lesser-developed countries wholesale markets to result, according to a later FDIC
prior to the August 1982 start of suddenly withdraw funding report on the Continental Illinois
the major LDC crisis of the from a damaged bank, debacle,5 the banks lending to
1980s. spinning the institution into a commercial and industrial clients grew
funding liquidity crisis as from $5 billion to $14 billion between
With investors and creditors potentially fatal as any 1976 and 1981.
spooked by rumors that the nineteenth-century run on a
bank might fail or be taken bank by retail depositors. Throughout this extended honeymoon
over, Continental was quickly period, the growth strategy seemed to
shut out of its usual domestic give good results. In the late 1970s,
and international wholesale Continental achieved an above-
Lessons learned
funding markets. average return on equity putting it at
the top of the commercial banking
Its tempting for league and was showered with praise
By May 17, regulatory agencies management to grow an by equity analysts. In turn, its share
and the banking industry had institution by offering price moved upwards, doubling in the
arranged billions of dollars in loans to the same credit- five years to 1979 and continuing to
emergency funding for the hungry industry sectors. rise to a peak in June 1981 (an
stricken giant. And in a move That incentive should be exceptional performance).
that remains controversial balanced by ensuring
almost 20 years later, the that portfolio But Continentals focus on commercial
Federal Deposit Insurance concentration risks are clients many of its peers diversified
Corporation tried to stem the correctly measured and their lines of business to include large
bleeding away of the banks factored into lending retail businesses meant that it needed
funds by extending a guarantee decisions. to be a master of commercial credit
to uninsured depositors and Decentralized lending risk management in terms of loan
creditors at the bank giving decisions require
underwriting and portfolio risk bank that specialized in oil selling short-term certificates of
management. and gas sector loans. While deposit on the wholesale money
Penn Square originated markets, sourcing only 20% of its
Commercial banking, after all, large volumes of loans to the funding from traditional retail deposits.
is notoriously dependent on historically risky exploration
national and regional economic sector of the US energy The banks funding strategy meant
cycles. A commercial banks industry, Continental that Continental was vulnerable to the
interest rate margin the positive participated bought a share wholesale funding markets
gap between the rate a bank in the smaller banks lending interpretation of its concentrated
pays depositors for funds and book, ultimately to the tune exposure to the energy and LDC
the interest rate it is able to of hundreds of millions of credit sectors. That worked well
charge borrowers can be dollars. during the 1970s, but both sectors
quickly eaten up by any jump in faced extraordinary challenges as the
customer default rates when Continental also expanded 1980s dawned.
recession bites. its assets in another credit-
hungry sector by lending to After years of oil price rises and
One result of this is that fast- lesser-developed countries industry expansion, oil prices began
growing commercial banks are in Latin America such as to drop in April 1981. They continued
often in danger of buying Mexico. Many large to decline for a number of years,
market share by lending at commercial US banks along with the fortunes of energy-
rates that will not offset the followed the same strategy sector companies. Exploration and
default risk of their loans over in the late 1970s. But drilling companies were inevitably
the entire economic cycle. Continentals credit among the first to bear the full brunt of
(Early-cycle default rates are exposures were the downturn. Continentals share
reassuringly but deceptively compounded by its unusual price began a steep decline, losing
low; they can change funding strategy. over half of its value from mid 1981 to
significantly as macro- mid 1982.
economic conditions change.) Traditionally, banks fund
growth in their lending Through the first half of 1982, most
This is a particular danger activities by attracting larger analysts continued to think that any
when banks concentrate volumes of savings from deterioration in Continentals credit
lending in a particular industry retail depositors. portfolio would threaten the banks
sector, the banking equivalent Continental, however, had profitability, not its solvency. After all,
of putting all your eggs in one only a limited retail Continental was a long-established
basket. Through the late presence, due in part to and substantial bank, with a good
1970s, Continental worked federal and local banking earnings record and a triple-A agency
hard to build up its energy regulations that restricted its rating for its debt.
industry business, a sector in ability to build a branch
which it felt it had special network. But two events in the summer of 1982
expertise. swung opinion against Continental.
This meant that the bank The most immediately important was
One of the tools that came to depend increasingly the collapse of Penn Square Bank in
Continental employed to speed on funding from the July 1982 under the weight of poorly
up this expansion in energy wholesale money markets. underwritten loans to the ailing energy
assets was its relationship with Indeed, by 1981, Continental sector. The collapse revealed the
Oklahoma-based Penn Square gained most of its funding extent of Continentals participation in
Bank, a $436-million asset through federal funds and by Penn Squares lending and underlined
the damage that was being OCC to improve its of angry customers forming outside
wrought on banks that had asset/liability management, the bank, the flight of capital was
specialized in energy-linked loan administration and conducted electronically by
lending. Continental was forced funding, 6 little could be institutional investors in the Eurodollar
to report $1.3 billion in non- done to prevent chronic money markets. Most of these
performing assets in the deterioration in the health of investors did not have to withdraw
second quarter of 1982. the loan portfolio it had built money; they simply refused to roll
up in the period before the over the money they had on deposit
The Penn Square collapse was Penn Square collapse. with the bank at short maturities.
closely followed by Mexicos Wrong-footed by rising
August 1982 debt default, interest rates and increasing With financial journalists questioning
which triggered the 1980s LDC LDC debt problems, Continentals solvency, the Office of
crisis. All of a sudden, Continental announced the Comptroller of the Currency
Continentals credit portfolio another increase in non- (OCC), its lead regulator, felt obliged
looked like a high-risk gamble. performing loans, to $2.3 to state publicly that it had no reason
billion, at the end of the first to question the banks soundness.
With market participants quarter of 1984.
becoming worried about The regulators reassurances were to
Continentals long-term Rumors circulated widely little avail. On May 11 the bank was
solvency, the bank began to about the banks financial obliged to borrow $3.6 billion from the
feel the liquidity squeeze condition during the spring of Federal Reserves discount window to
inherent in its funding strategy. that year. International banks make good the outflow of funds.
It found itself paying higher began to charge Continental Within days 16 banks had put
rates on its certificates of higher rates for funds, a together an additional $4.5 billion
deposit as it fell out of favor widening of the banks credit emergency package of loans for the
with savvy domestic spread that may itself have stricken bank but the run on the bank
counterparties in the wholesale triggered further rumors continued.
money markets. Increasingly, when it became the subject
the bank turned to the foreign of a news wire story on May Meanwhile, the reliance of other US
Eurodollar money markets for 8. 7 On May 9, rumors of banks on Continental led to fears that
funding, which it could secure Continentals credit a failure of the bank would trigger a
by paying relatively high rates. problems, and of a possible loss of confidence in US banks by
This, however, depressed the take-over, reached a foreign investors and lead to a
banks profit margin and left it crescendo as a run on the systemic crisis. In particular, some
vulnerable to any further panic banks funding instruments 2300 US banks held deposits in
about its creditworthiness in the developed in Tokyo and on correspondence accounts at
international markets. other international money Continental, leading to fears that an
markets. unknown number perhaps a hundred
The bank struggled through or so might be catapulted into
1983, its financial health The flight of billions of dollars insolvency in the event of a crisis.
boosted by the one-off sale of a of short-term funding from (Studies after the event have tended
profitable credit card business. Continental in the days to downplay the likely number of
But though there were following May 9 was rather fatalities, suggesting that only a
occasional rallies in like a classic nineteenth- handful of small banks were at risk of
Continentals share price, these century run on a bank by failure.8 )
proved short lived. And while depositors. The difference
the bank agreed a plan with the was that instead of queues
The Comptroller of the The FDIC extension of its a special unit (under strict FDIC
Currency at the time, Todd guarantee to all uninsured oversight).
Conover, later summed up the depositors and creditors was
regulators dilemma at the highly unusual. It was made Under the permanent assistance
moment of crisis: because most of program, the FDIC also acquired
Continentals funding was in preferred stock in Continentals
We debated at some length the form of uninsured holding company, in return for
how to handle the situation. In deposits and regulators infusing $1 billion in equity capital into
our collective judgment, had believed that this would the bank. This transaction effectively
Continental failed and been continue to drive the bank left the government agency as the
treated in a way in which run unless such an 80% owner of the bank a
depositors and creditors were assurance was given. nationalization in everything but
not made whole, we could very name.10
well have seen a national, if not The emergency measures
international, financial crisis the provided a temporary The aftermath
dimensions of which were breathing space in which The rescue package meant that,
difficult to imagine. None of us regulators looked for another controversially, creditors who held the
wanted to find out.9 institution that would agree debt of the bank holding company did
to take over Continental. The not lose their money. It also gave
On May 17, the FDIC, Federal worries about Continentals fresh life to the widely held belief that
Reserve and OCC announced impaired portfolio and legal some banks were simply too big to fail
how much they were willing to entanglements were such that their demise would have such
pay to remain ignorant of that the search proved disastrous systemic implications that
whether Continental really was fruitless. regulators would never permit them to
too big to fail. The package In July, regulators collapse.
they announced in a joint press hammered out a
statement included: controversial approach to But the label too big too fail is
permanently rescuing the potentially misleading. Shareholders
- An additional $2 billion in institution under which the in the bank lost most of the value of
funding for the bank arranged FDIC would purchase some their investment immediately after the
by the FDIC and the banking $4.5 billion book value of FDICs stock purchase. They lost the
industry; impaired loans with an rest of the value of their investment
- Federal Reserve assurances adjusted book value of $3.5 later on, when the FDIC exercised an
about providing liquidity; billion in return for assuming option to purchase the remaining
- Twenty-four major banks $3.5 billion of the banks shares. (The option became
would provide $5.3 billion in Federal Reserve debt. exercisable because the losses from
unsecured funds until a more the FDIC-assumed impaired loan
permanent solution could be The so-called permanent portfolio reached a pre-agreed level.)
found; and, controversially, assistance program was put
- The FDIC said it would make into place on 26 September. Even so, the Continental rescue
good all of the banks But the impaired loan clearly suggested that uninsured
depositors and creditors, portfolio, composed largely depositors and creditors would be
setting aside the $100,000 limit of energy and international bailed out using taxpayers money if
on deposit insurance that shipping loans, was so large regulators became scared enough
should have governed its and complex that the FDIC about the systemic effects of letting a
payouts. had to ask Continental itself large bank go to the wall. Shortly after
to manage the loans through the Continental episode, regulators
testifying to Congress admitted culminate in a violent 14 May: 16 banks put together rescue
that the eleven largest banks in explosion of market rumor package of funding, but the run on
the US were indeed regarded and funding liquidity risk. Continental continues
as too big to fail.
Timeline 17 May: Unprecedented interim
This implied government assistance package announced by
guarantee upset smaller banks 1976 - 1981: Continental panicked regulators. Uninsured
in the US, who argued that the grows fast, lending to the depositors and creditors given FDIC
too big to fail concept was, in energy sector and lesser- assurances.
effect, a government subsidy developed countries
for larger banks. Following the July: With it proving difficult to find a
savings and loan sector 1981: Continental hits a high purchaser for the bank, regulators
debacle later in the 1980s, a point in terms of asset size work with Continental to devise a
series of reforms of US banking and by now employs some permanent solution
regulation addressed some of 12,000 people
the issues of the too big to fail 26 September: Permanent solution
debate, particularly in terms of 1981: The US energy sector, put in place, effectively nationalizing
making sure that uninsured hit by oil price falls, moves Continental using FDIC funds
depositors bore a greater towards recession
proportion of the cost of bank 1991: FDIC sells off its last equity
failure.11 July 1982: Energy-sector stake in Continental, bringing the
specialist Penn Square Bank rescue program to a close some
But the question of how fails, causing concern about seven years after the banks near
regulators will react when they Continental, a major collapse
are again faced with potential participant in Penn Squares
systemic repercussions from risky lending program Notes
1
the meltdown of a very large More precisely, the Continental
bank remains open. The August 1982: Mexico Illinois National Bank and Trust
answer is more important than defaults on debt, sparking Company.
ever: since 1984 major US LDC debt crisis 2
banks have vastly increased in Continental Illinois remains the
size through merger and Spring 1984: With non- largest bank by asset size that has
acquisition.12 performing loans rising been the subject of US government
sharply, Continentals critics agency rescue, but it does not
The rescue of Continental are now wondering about its represent the most expensive rescue
Illinois had many lessons for solvency operation. At 3.2% of bank assets, the
regulators, but these should not severity of losses in the Continental
be allowed to outshine the 9 May: Final liquidity crisis credit portfolio is relatively low
lessons the story contains for begins in Eurodollar markets compared to some other bank
bank risk managers. as rumors swirl about failures. Continental Illinois National
Continentals troubles remain Continentals Bank and Trust Company, Chapter 4
an object lesson in how a creditworthiness of Managing the Crisis: The FDIC and
disaster can begin with RTC Experience , FDIC, page 546.
underwriting decisions, 11 May: Continental forced 3
snowball through the poor to borrow $3.6 billion through Continental Illinois National Bank
management of portfolio Fed discount window and Trust Company, page 558.
concentration risk, and
4 10
A recent European Central Albeit one that was Kuritzkes, Til Schuermann and Scott
Bank report, Development in intended to be temporary. Weiner, Deposit Insurance and Risk
Banks Liquidity Profile and The details of the Management of the US Banking
Management, May 2002, page complicated permanent System: How Much? How Safe? Who
31, notes that: Owing to the rescue package are outlined Pays?, working paper, April 2002.
increasing reliance on credit- in Continental Illinois
sensitive wholesale fund National Bank and Trust
providers, whether on a Company, pages 5534. The
secured or unsecured basis, a FDIC gradually sold off its
typical liquidity crisis today position in Continental,
would probably be more like disposing of the last piece of
the Continental Illinois case in equity in the bank in 1991.
the United States [than a
11
traditional run on deposits]. Notably the Federal
Deposit Insurance
5
Lee Davison, Continental Corporation Improvement
Illinois and Too Big to Fail, Act (FDICIA) of 1991.
Chapter 7, Volume 1, History of Provisions also included
the Eighties Lessons for the making more formal and
Future , Federal Deposit elaborate the government
Insurance Corporation, 1997. agency decision to rescue a
This excellent FDIC account is major bank, and restricting
a principal source for the use of the discount window
narrative in this ERisk case and interbank lending. The
history. issue of whether these
reforms have reduced the
6
Continental Illinois and Too markets perception that
Big to Fail, page 246. some banks are too big to
fail is discussed in many
7
Continental Illinois National regulatory and some
Bank and Trust Company, academic papers, including
page 547. Maria Penas and Halak
Unal, Too Big To Fail Gains
8
G. Kaufman and K. Scott, In Bank Mergers, working
Does Bank Regulation Retard paper, 2001.
or Contribute To Systemic
12
Risk?, working paper, Continental Illinois was
December 2000, page 10. around the ninth largest
bank in the US at the time of
9
Quoted in Incentives and its near-failure. By the year
Banking, text of speech made 2000, more than 20
by J. Alfred Broaddus, Jr, institutions of a similar size
President, Federal Reserve or larger existed in the US,
Bank of Richmond, 26 one of the biggest being the
September 1999. Bank of America with an
extraordinary $584 billion in
assets. See Andrew

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